Let’s start with a few standard private equity return terms:
So, what does this have to do with anything? Well, most sane investors put aside the entire committed amount from day 1, because it would be very risky to commit more capital than you currently have. Why? Because if you default on a “call notice”, you could lose your entire investment without reimbursement, or at best, have it sold at a heavy discount to a secondary buyer.
And, how does this result in misleading private equity returns? Well, private equity funds use the internal rate of return (IRR) on cash inflows and outflows as their private equity return metric. The implication is that the return doesn’t account for you having to hold cash. A fund may not even call a dime until year nine, then return double your money in year 10, and then quote a 100% return for the fund. The fact is, you held that cash for nine years at a negligible rate, and achieved an overall return of only a few percent on the commitment (certainly not 100%).
This issue isn’t so black and white because,
However, you really do need to hold the cash if you want to limit your risk to the risk of the investment itself. And you really do need to hold it in a risk free investment, again, if you want to limit your risk to that of the private equity investment. Ipso facto, the private equity return from the risk free investment should be included in the overall return.
So what effect does this have in economic terms? Well, most private equity firms look to return 2x the original cash investment. But remember, 2x cash is a 100% private equity return, not a 200% return. Now, if my math from many years ago serves me well, that’s a ~7% private equity return for a 10 year investment. Of course, that’s too conservative as you receive distributions well before the 10 years is up. So let’s take an average of five and 10 years. That equates to about 10-11% p.a. Certainly not what most private equiteers espouse.
Sure, my methodology and math isn’t going to win any prizes, but I’m sure you get my point.